In December 2008, BCG-IESE predicted a significant shake-out in the private equity industry leading to the disappearance of 20% to 40% of firms. Since then, several firms have gone out of business, some have reduced their current fund commitments, and others have reduced their teams, including senior partners. Prof Heinrich Liechtenstein, IESE Business School, and Heino Meerkatt, Boston Consulting Group

In July 2009, we forecast that private equity’s limited partners would – on average, but with significant variation – stay committed to this asset class or even increase their allocation relative to other asset classes. In the past six months, limited partners have indicated they are willing to commit new funds and have done so.

At the same time, however, limited partners investing in private equity have been more forceful in defining the criteria and terms they expect and have made it clear they will perform more sophisticated due diligence before committing new funds. In particular, they are scrutinising the importance of operational value creation (growth of earnings before interest, tax, depreciation and amortisation) versus financial levers (multiple expansion and deleveraging).

“Operational value creation is the key element in private equity that will distinguish the winners from those that disappear,” said a limited partner – one of the largest investors in private equity funds – interviewed during our research. “The time to bet on financial levers is over.” Another said: “Operational value creation is the result of a business mentality, and financial levers are the result of a trader mentality.”

Returns from deleveraging or multiple expansion are mainly a result of arbitrage between debt and equity holders or between buyers and sellers of equity. These levers create value for the shareholder but do not add to the competitive position of the company, nor are they sustainable.

For this reason, limited partners will allocate their capital commitments increasingly to those private equity funds that can prove their track record in operational value creation. For buyout firms, it is a matter of survival to prove they can do so. “They all say the same thing,” said another limited partner about private equity’s business model for value creation, “but the differences among firms are huge.”

In our discussions, limited partners cited nine levers with a particular impact on operational value. These can be divided between “table stakes” (those that companies must have in order to be on the radar screen of investors) and “differentiators” (those that make a real difference to investors). Table stakes, which are easier to prescribe and acquire, include frequent evaluation of top management, strategy that yields a quantum leap forward, closeness to the business, a sense of urgency, management incentives with a strong element of risk-sharing, and an effective board with firepower.

Differentiators, which are driven by capabilities and experience and take longer to acquire, include ownership experience, industry expertise and regional experience.

Limited partners in private equity and other institutional investors who have learned the lessons of the financial crisis will base their investment decisions more and more on whether the owners, or representative of the owners (that is, a buyout firm, a fund’s managers or the board of a public company) are truly engaged. Any owner of a family-run company, any board member and any private equity manager must therefore ask: “How can I add to the competitive position of my company?”